Consumer Choice & Market DemandNeoclassical Model

Marginalism

Consumer Sovereignty

Utility

Law of Diminishing Marginal Returns

Substitution Effect

Income Effect

Market Demand

Behavioral Economics

Prospect Theory

Neoclassical Economics

Economics is divided roughly into two sections: Microeconomics and Macroeconomics. Microeconomics examines the small-scale economic decisions of individuals and businesses. Macroeconomics examines the large-scale economic decisions of governments and international economics.

The core of microeconomics was developed by Alfred Marshall and published in his book Principles of Economics. Marshall is at the center of a economics group called the Neoclassical school of economics because their approach to economics held many of the same ideas as the “classical” economists (like Adam Smith and David Ricardo) but approached economics from a different perspective. Classical economist thought mostly about production issues. In contrast, Neoclassical economists focused looking at the decision making process of individuals and then scaled up to their theories to entire economy. Working from the core assumption that people are rational agents making choices to maximize their profits or enjoyment within constraints, these economists developed ideas of market equilibrium and general economy-wide equilibrium.

The Rise of “Economic Man”

The Neoclassical economists developed their ideas with the starting point of how humans make choices – to do this, they made assumptions that people were rational individuals who made decisions using perfect information and were interested in maximizing their happiness or their profits.

Clearly, these assumptions were not accurate to reality. The Neoclassical economists recognized this, yet they considered their assumptions sufficiently realistic to develop useful economic theories – these assumptions provide a good starting point for developing “tools” for economic analysis.

These ideas can sometime result in some startling yet informative insights. The economist Gary Becker used the ideas of rational agents to study many areas outside of traditional scope of economics such as marriage and childcare. Becker argued that people choose their spouses not just for love, but also for the costs and benefits their partners could bring. He also said that parents see children as an investment and base child care decisions on the cost compared to the “rate of return”. More controversially, Becker also applied economics to looking at racism and crime.

Marginal Analysis and the Value Paradox

The Neoclassical economists recognized that people made decisions one item at time not in batches. For example, when buying ice cream, you make your decision cone by cone, you do not decide to buy a summer’s worth of ice cream at one time. The neoclassical economists called this incremental way of making decisions “marginalism”. Neoclassical economists viewed people as making decisions based on the marginal benefit from consuming the next unit compared to the marginal cost getting the next item.

An example of marginalist thinking is the diamond-water paradox, which had troubled economists going back to Adam Smith. The question is “why are diamonds, which are useless to human life, so expensive while water, which is necessary, is so cheap. The paradox is that market prices seem out of line with “value”.

The Neoclassical economists held that “value” was subjective and that prices reflected how much people wanted to pay for one more item of something. Water has a low price because it is common and people will not pay very much for another glass of water. However, diamonds are rare and people will pay a lot for one more.

Market Demand and Consumer Sovereignty

In a market economy, goods are produced and sold only because people are willing and able to buy the goods. Anything not sold is a burden for the producer – a burden that a self-interested producer would seek to avoid. Basically, nothing is produced unless there is somebody who both wants it and is willing to pay for it. This is the idea of consumer sovereignty: the condition in a market where consumer choices about purchasing goods determines what an economy produces. The idea of consumer sovereignty places the individual at the center of a free market society and provides an explanation for why societies with market economies tend to be happier and less wasteful than command economies.

The concept of consumer sovereignty has an important philosophical point because it gets to the question of the purpose of the economy. Neoclassical economists held that the purpose of the economy was to create the greatest amount of happiness in society. The hard part with defining “happiness” is that it is entirely subjective – beauty is in the eye of the beholder. The nice part of a market system is that there is no need to need to settle on a single definition of “happiness”.

Consumer Choice and Utility

Economist John Stuart Mill used the word “utility” to denote the satisfaction and enjoyment people get from consuming goods. Economists believe that people can assess a value to the amount of utility they get from each good that they consume – economist call each unit of enjoyment a “util”.  

Economist view utility to be an entirely subjective and individual form of measurement. That each person has their own way of assigning and measuring the enjoyment they receive from anything and that it is impossible to compare the enjoyment that one person receives to the enjoyment another person receives from the same good. One person’s “util” means nothing to anyone else. From an economist’s vantage point, beauty is in the eye of the beholder – and how that person measures beauty is their business. Economists use the concept of utility to explain individual choice.

The subjective nature of utility is the reason that a very unequal allocation of goods can be considered Pareto Efficient – this means taking something from the rich and giving it to the poor will not improve social utility since it is impossible to know how much utility the rich person would lose and the poor would gain.

Total Utility

Using the concept of utility, economists say that as people consume more goods, the combined utils of their enjoyment add up and their total utility increases. Mathematically, this is shown as: TU = f (Qc) Total Utility is a function of quantity consumed The graph shows a Total Utility Curve:

Clearly, as people consume goods, their total utility increases up to a point, after which it begins to decline as they consume continue to consume the good. Logically, people should only consume a good when it adds to their total utility – the goal is to maximize utility.

Relationship of Total Utility and Marginal Utility

Economists hold that people make their consumption choices based on the goal of maximizing their total utility. In deciding how much to consumer, economists view that people consume good sequentially, so when making a decision about consumption people think about how much enjoyment they will get from the next time they consume – that is to say that people “think at the margin”. Economists argue that a person thinks about their marginal utility or the amount of utility they will receive from the next unit that they consume. Mathematically, a person’s marginal utility is the first derivative of their total utility function:

MU = dTU = f’(Qc) dQc

Marginal utility is how much a change in the quantity consumed causes a change in the amount of total utility.

Total & Marginal Utility

The graphs to the right show the relationship between the total utility curve and the marginal utility curve.

Mathematically, the marginal utility curve is the slope of the total utility curve.

MU = dTU = f’(Qc) dQc

Note – the point of greatest total utility is the point where the marginal utility curve is zero.

Law of Diminishing Marginal Utility

Marginal utility shows how with each additional unit consumed the consumer receives less additional enjoyment – until they reach a point of saturation, after which additional consumption causes them to lose utility.

Economists refer to the downward or negative slope of the Marginal Utility Curve by citing the Law of Diminishing Marginal Utility – the marginal utility received from consuming an additional unit of the good is smaller than the marginal utility from consuming the previous unit of the good.

The logic of the Law of Diminishing Marginal Utility would say that a person should stop consuming a good when the marginal utility from consuming that good is zero – in other words, they gain no additional utility from additional consumption.

Consumer Choice

When deciding how much of any one good to consume, the Law of Diminishing Marginal Utility is a good guide. However, how do people make decisions when choosing between consuming two different goods? For example, in a restaurant people do not choose between hamburgers and soda. They decide how many hamburgers to have with how many sodas. In this case, their utility function could be described as: TU = f (QH, QS)

When considering two goods, the consumer needs to think of combinations of goods and rank them in order – some combinations are similar, others are either preferred or not preferred. This can be shown on an indifference curve shown to the right – points C and G give the same amount of utility. Any combination in the yellow area gives more utility.

Budget Constraint

Economics is the study of making choices about how to maximize benefits when constrained by limited resources.

The limited resources in consumer choice are the income of the consumer and the price of goods the consumer is trying to get.

The budget constraint line on the graph to the right shows all the possible options that a consumer can afford based on their income and the prices of goods.

Consumers make the choice that will maximize their utility in the face of their budget constraint. This means that they will chose to consume the combination of goods at the point where their indifference curve is tangent (barely touches) their budget constraint – i.e. the level of utility they can barely afford based on their current income and prices.

The graph to the right shows how point C represents the best affordable point for the consumer.

Utility Maximization with a Budget Constraint

Marginal Utility and Price

Another way of seeing the interplay of utility and prices and consumer choice is to think about how people make choices at the margin as they consume things sequentially. Consider how somebody might decide whether to buy one thing or another – that person will not be thinking about their total utility, but instead they will focus on the marginal utility they get from each item and the price of each item, with the goal of maximizing their total utility.

The logic is that they should consume so that the marginal utility of last dollar spent on one good is equal to the marginal utility of the last dollar spent on any other good.

Mathematically, this relationship is described as: 

MUA = MUB

PA PB

Individual Demand

The two central concepts in the theory of consumer choice are that people seek to maximize consumption with in their budget restraints. An individual’s demand function could be written as:

QD = f(P, I, U) Quantity demanded is a function of price, income & utility.

This equation contains important concepts:

Substitution Effect – how a change in the price of a good effects the amount consumed because the consume switches to an alternative good. For example an increase in the price of Coke will cause the quantity demanded of Coke to go down as more people substitute Pepsi for Coke.

Income Effect – how a change in the price of a good effects the amount purchased it effected the purchasing power of the consumer’s income. If the price of good A decreases, the consumer will feel as if their income has increases because they can afford to buy more of good A. But, that does not mean they will buy more of good A. If good A is a normal good they will buy more. However, if the good is an inferior good they will by less of it.

Formation of a Market Demand Curve The cornerstone of any market economy is the idea that all individuals are different. This is reinforced by connecting consumer sovereignty and consumer choice. Still, in a market, the buyers or consumers are characterized in the singular as Demand. Economists make the leap from the behavior of the individual to that of the group by saying the market demand curve is the summation of individual consumers’ demand curves.

Limits to Rationality and Theory The theory of consumer choice explains the structure of the demand curve and is an important part of neo-classical economic theory. The assumptions that support the theory of consumer choice – specifically the assumptions of rationality and subjective nature of utility – are crucially important to the Neoclassical perspective that markets result in a Pareto Efficient allocation of goods in society.

Neo-classical economist always knew that this was a weak point in their theory, however they argued that their assumptions were sufficiently good to explain most behavior and that there was not a good alternative to their assumptions.

However, the development of behavioral economics, which incorporated ideas from psychology and brain science into economics has challenged many of the assumptions of the neo-classical theory about who well markets work and if they are always result in economically and socially optimal outcomes – this in turn is having an affect on economic policies.

Prospect Theory – Root of Behavioral Economics

The field of Behavioral Economics began with psychologists Amos Tversky and Daniel Kahneman when they published their paper, “Prospect Theory: An Analysis of Decision Under Risk”, which showed that when people were faced with uncertain situations they did not act in a way that was rational and self-interested.

For example, what would you do if you were given the choice of definitely getting $1000 or having a 50% chance of getting $2,500?

Rationally, you should take the “50% chance of getting $2,500” option since the expected value is more than the guaranteed $1000. However, many people would choose the $1000.

Economists had long known about this and described people who would choose the $1000 as “risk adverse” – they argued that a rationally risk adverse person would always choose the safe option.

Tversky and Kahneman challenged economists by showing that people were risk adverse when facing gains but risk loving when facing losses – which means that how a person perceives a situation will affect how they act.

Framing and Risk

Tversky and Kahneman recognition that people were risk adverse when facing gains but risk loving when facing losses meant that how a choice was “framed” would have a significant affect on the choices people made. Going back to the previous example what was your choice then presented with the situation:

What would you do if you were given the choice of definitely getting $1000 or having a 50% chance of getting $2,500?

Now, what would you do if you were given the choice of definitely losing $1000 or having a 50% chance of losing $2,500?

Did you make the same choice in both decisions? Neoclassical rational thinking says that you should. Tversky and Kahneman showed people consistently made different choices.

Prospect Theory - Graph

The value of B < C

Rationality vs. Heuristics

In contrast to the Neoclassical view that people are rational economic agents that evaluate choices with the goal of maximizing their outcome, behavioral economists argue that it is too hard to rationally make a complex decision when faced with large amounts of uncertainty – instead, people rely on “rules of thumb” which produce “good enough” results. Behavioral economists use the term “heuristics” to describe people using a “rule of thumb” to make a decision. Here is an example:

You are 30 years old and make $60,000 a year. How much should you put in a retirement account each year?

Classical economics holds that the economic rational agent should be able to determine the exact dollar amount to maximize their utility – both now and in the future.

Behavioral economics recognizes that no sane person would spend the time on solving this very complex problem. Instead, people use “heuristics” - Save 10% a year and you will do fine.

Other Challenges from Behavioral Economics

Clearly behavioral economics recognizes how people live their lives in a way that the Neoclassical “rational agent” economics misses. Behavioral economists have developed many other challenges to the Neoclassical perspective, such as:

•Confirmation Bias – People do not rationally evaluate all evidence, they tend to put more weight on the evidence that confirms the way they already think – this results in a form of “willful blindness”.•Endowment Effect – People value something more because they own it. For example, if somebody buys something for $10, they will have to be paid more than $10 to give it up.•Intertemporal Choice – People change choices based on whether they need to wait right now or at some point in the future – people place a lower value on time in “far” future than in the “near” future. For example, a hungry person will choose one french fry now instead of two in 5 minutes, but if they face the choice of one in 30 minutes and two in 35 minutes, they will wait the extra 5 minutes. •Fairness – People will reject deals in which they benefit if they view the other person as having much greater benefits.

Neoclassical or Behavioral Economics

The rise of wide-spread interest in behavioral economics is largely because of the 2008 Crisis – this is one reason that Robert Schiller, who used behavioral economic ideas to describe the housing bubble before the crisis was awarded 2013 Nobel Prize.

However, it is not clear that behavioral economics trumps the Neoclassical model. While behavioral economics does describe the world more realistically than the Neoclassical model, there is no “behavioral economics model” that provided an organized and rigorous way of understanding the economy – at this point behavioral economics is a bunch of different ideas. So many economists find behavioral economics interesting and useful in places, but not as something that will overturn the Neoclassical model – it is more of a modification of the Neoclassical model.

This point can be seen in the fact that Robert Schiller shared the Nobel Prize with Eugene Fama who developed the Efficient Market Hypothesis, which holds that rational agents making decisions in markets make markets efficient in adapting to changes in the world, and who is a strong defender of the Neoclassical perspective.